The Effects of Tax Salience and Tax Experience on Individual Work Efforts in a Framed Field Experiment

Transcription

1 D I S C U S S I O N P A P E R S E R I E S IZA DP No The Effects of Tax Salience and Tax Experience on Individual Work Efforts in a Framed Field Experiment Martin Fochmann Joachim Weimann October 2011 Forschungsinstitut zur Zukunft der Arbeit Institute for the Study of Labor

2 The Effects of Tax Salience and Tax Experience on Individual Work Efforts in a Framed Field Experiment Martin Fochmann University of Magdeburg Joachim Weimann University of Magdeburg and IZA Discussion Paper No October 2011 IZA P.O. Box Bonn Germany Phone: Fax: iza@iza.org Any opinions expressed here are those of the author(s) and not those of IZA. Research published in this series may include views on policy, but the institute itself takes no institutional policy positions. The Institute for the Study of Labor (IZA) in Bonn is a local and virtual international research center and a place of communication between science, politics and business. IZA is an independent nonprofit organization supported by Deutsche Post Foundation. The center is associated with the University of Bonn and offers a stimulating research environment through its international network, workshops and conferences, data service, project support, research visits and doctoral program. IZA engages in (i) original and internationally competitive research in all fields of labor economics, (ii) development of policy concepts, and (iii) dissemination of research results and concepts to the interested public. IZA Discussion Papers often represent preliminary work and are circulated to encourage discussion. Citation of such a paper should account for its provisional character. A revised version may be available directly from the author.

3 IZA Discussion Paper No October 2011 ABSTRACT The Effects of Tax Salience and Tax Experience on Individual Work Efforts in a Framed Field Experiment * We conduct a framed field experiment with 245 employed persons (no students) as subjects and a real tax, which is levied on the subjects income from working in our real effort task. In our first three treatments, the net wage is constant but gross wages are subject to different constant marginal tax rates (0, 25%, 50%). It turns out that the effort is significantly higher under the tax than in the no tax treatment. Subjects perceive a too high net wage because they underestimate the tax. We conjecture that tax perception depends on the tax rate, the presentation of the tax and the experience subjects have with taxation. These conjectures are confirmed in four further treatments employing a direct and an indirect progressive tax scale. It turns out that simple at taxes are particularly prone to being misperceived because their simplicity reduces the tax salience. JEL Classification: C91, D14, H24 Keywords: field experiment, real effort experiment, tax perception, tax salience, tax experience, behavioral economics Corresponding author: Martin Fochmann Chair of Economic Policy University of Magdeburg PO Box Magdeburg Germany martin.fochmann@ovgu.de * We would like to thank Wolfram Richter, Peter Katuščák, and the participants of the Asia-Pacific Economic Science Association Conference, the International Economic Science Association Conference, and the Jahrestagung der Gesellschaft für experimentelle Wirtschaftsforschung for helpful comments and suggestions. We gratefully acknowledge funding by the German Federal Ministry of Finance.

4 1 Introduction In the economic literature on taxes, behavioral aspects do not usually play a prominent role. For example, the theory of optimal taxation assumes that taxpayers adapt to a given tax scale rationally by maximizing their utility. Phenomena like inequality aversion (Fehr and Schmidt, 1999; Bolton and Ockenfels, 2000), reciprocity (Fehr and Gächter, 1998) or altruism (Andreoni and Miller, 2002), intensively discussed in the area of behavioral economics, do not play a role in this theory for good reasons. On the other hand, it must be realized that there is experimental evidence that a fundamental assumption made in theories about the effects of taxation may be violated in reality: the assumption that taxpayers perceive the tax as implemented by the government. There is a variety of papers showing that subjects in laboratory experiments or the participants in surveys are not aware of their true tax burden. For example, Gensemer et al. (1965), Morgan et al. (1977), Lewis (1978) and Rupert and Fischer (1995) find in their surveys that taxpayers misestimate their marginal tax rates. In a laboratory experiment, Bartolome (1995) shows that most of the subjects underestimate their tax burden in investment decisions since they use the average tax rate instead of the marginal tax rate. More recently, Chetty et al. (2009) show in a field experiment that subjects do not consider taxes correctly when they decide on their consumption of goods in a store. In an assortment of studies, the salience of a tax the degree of tax visibility is identified as the main determinant of tax perception. In a laboratory experiment, Rupert and Wright (1998) use four different presentation forms of a tax scale that differ in the visibility of the marginal tax rates, and find that the quality of investment decisions increases with the visibility. Sausgruber and Tyran (2005) find that subjects are much more aware of taxes if they have to pay the tax bill than if the other market side has to pay. Chetty et al. (2009) observe in their field experiment that an explicit tax posting on price tags induces consumers to pay more attention to taxes. In the same manner, Finkelstein (2009) finds that the awareness of tolls is much lower when individuals pay the toll automatically by using an electronic toll collection system than when paying in cash. All of these studies reveal that the higher the salience of a tax, the higher the tax perception. Thus, the degree of tax consideration in individuals decisions is affected by tax salience. Given these observations, the question arises, why is tax perception biased or, considering it the other way around, what are the necessary conditions for a correct perception of tax? Answering this question is not only important for governments trying to create tax-systems that produce correctly perceived taxes, but also for the 1

5 economic analysis of taxes. For example, if taxes are misperceived, this affects the welfare analysis of taxation because the excess burden of taxes becomes smaller or greater due to the perception bias. In this paper, we investigate the way taxes are perceived in a framed field experiment 1 with a real effort task in which subjects have to decide on their labor supply. Some experiments described in the literature already use real effort designs to analyze the impact of taxes. But the experimental designs used in these experiments do not allow potential misperceptions of taxes to be investigated. For example, in the experiments of Sillamaa (1999a, 1999b, 1999c) and Swenson (1988), only the after-tax wage rate was announced and any kind of tax framing was avoided. Furthermore, in order to control for income effects, the tax revenue is redistributed to the subjects. The work-leisure decision is established in the laboratory by offering subjects newspapers and computer games they could use instead of working which is quite different from the real work-leisure decision people have to make when they decide on their labor supply. In contrast to the existing literature, we designed the experiments in such a way as to achieve as much external validity as possible. For this reason, we used employed people as subjects (no students) and conducted a real effort experiment. Furthermore, subjects had to make a real work-leisure decision because they decided not only about their effort but also about the time they spent on work. There was no time restriction. Because the experiment was financed by the German Federal Ministry of Finance, we could use real taxes. On the other hand, we did not redistribute the taxes to the subjects because, in the real world, the quantity of public goods taxpayers consume is, in fact, independent of the taxes they personally pay. The experiments are designed to investigate three different hypotheses concerning the determinants of tax perception. The first hypothesis is that tax perception depends on the tax rate itself. We conjecture that when tax rates are low, subjects will tend to underestimate the tax and that the tax bias will become smaller, the higher the tax rates. We formulate this hypothesis for linear tax scales only in order to avoid the difficulty of differentiating between marginal and average tax rates. Our second hypothesis concerns the way taxes are presented to the taxpayer. To investigate this hypothesis, we use two tax scales that are more difficult and complex: an indirect progressive tax and a direct progressive tax. These complex scales are presented in a more or less transparent way (either only verbally or with a graphical illustration). We conjecture that tax perception depends on the transparency of the 1 According to Harrison and List (2004) our experiment can be regarded as a framed field experiment because we used employees as subjects and a real tax on labor income. 2

6 tax presentation. The third hypothesis concerns the characteristic of the subjects. Our conjecture in this case is that the experience subjects have with the taxation of earned labor income affects tax perception: the more experience subjects have, the smaller the tax bias will be. In the next section, we will briefly describe the theoretical framework of our experiment. Section three describes the experimental design and presents the three hypotheses more precisely. The results are presented in section four and discussed in the final section. 2 Theoretical framework In our experiment, participants are asked to produce a good in a real effort task without any time restriction. The total number of goods produced by subject i is x i and the subject earns the gross wage rate w for each unit of x i. Income is subject to an income tax and the total tax burden of an individual is τ(x i ). The total net of tax income equals wx i τ(x i ). The production costs c (subject s disutility of labor) depend on the output level and we assume that c(x i) x i > 0 and 2 c(x i ) 2 x i > 0. Because each subject decides on the working time individually, the output level x i depends on both the time t i a subject spends in the laboratory and on the effort level e i. The latter is defined as output quantity per time unit and measures the productivity of a participant approximately. The output level is then determined by x i = e i t i and the following payoff function results: π i (e i t i ) = we i t i τ(e i t i ) c(e i t i ) (1) As described above, the baseline hypothesis of this paper is that taxpayers do not perceive taxes correctly. To consider such a tax bias in our model, we introduce the variable ˆτ which represents the perceived tax burden. In the case of an underestimation (overestimation) of the tax effect, the perceived tax burden ˆτ is lower (higher) than the true tax burden τ. The difference between the perceived and the true value the tax bias is denoted as τ = ˆτ τ. Since individuals base their labor supply decisions on their perceived (expected) payoff, subjects are assumed to maximize: π i (e i t i ) = we i t i ˆτ(e i t i ) c(e i t i ) = we i t i τ(e i t i ) τ(e i t i ) c(e i t i ) (2) 3

7 ample. The solid line (45-degree line) represents an unbiased tax perception. The dashed line represents an underestimation of the tax effect, with the absolute tax (rate) bias increasing for tax rates less than and decreasing for tax rates greater than. perceived tax rate 1 1 true tax rate Figure 1: Figure Perceived 1: Perceived tax rate tax rate as as a function a of ofthe thetrue true tax rate tax rate t * If we normalize the time spent in the laboratory (t i condition 3 for Treatments the payoffand maximizing hypotheses effort: = 1), we get the necessary To derive our hypotheses, we will focus only on subjects work efforts. The decisions about w ˆτ = c(e i) (3) the time spent in the laboratory will be ignored because we do not have enough control over the In the opportunity optimum, costs the driving (perceived) these marginal decisions. net For wage example, rate it equals may be the the marginal case that effort a subject has costs. an appointment Given the assumptions later or that the made subject s for the wife cost or husband function, is the waiting optimal for dinner. effortthus, will we assume increasethat if the gross decision wage about ratetime w increases. and effort are Theadditively reaction separable. to an increase Subjects in the decide realhow hard (marginal) they are tax going rate to obviously work given depends their optimal on how chosen ˆτ depends labor time. on τ. 5 Turning to the relationship between the perceived tax burden ˆτ and the true tax burden τ, we assume that the tax bias is zero for tax rates (t) of 0% and 100%. The tax can be over- or underestimated for tax rates inbetween. In both cases, there has to be an area in which the difference between perceived and true tax rate firstly 5 increases and, therefore, also the tax (burden) bias, followed by an area in which Despite this difficulty, we decided to leave the decision on the length of the experiment to the subjects, because our aim was to create a real work-leisure decision. this difference and also the tax (burden) bias decreases. Figure 1 shows an example. The solid line (45-degree line) represents an 5 unbiased tax perception. The dashed line represents an underestimation of the tax effect, with the absolute tax (rate) bias increasing for tax rates less than t and decreasing for tax rates greater than t. 3 Treatments and hypotheses To derive our hypotheses, we will focus only on subjects efforts. The decisions about the time spent in the laboratory will be ignored because we do not have enough control over the opportunity costs driving these decisions. For example, it may be the case that a subject has an appointment later or that the subject s wife or husband is waiting for dinner. Thus, we assume that the decision about time and 4

8 effort are additively separable. Subjects decide how hard they are going to work given their optimal chosen labor time. 2 It is well known that the ability to do simple tasks improves with practice. The learning process can best be described by the Power Law of Learning (PLL) 3 which states that productivity is an isoelastic function of practice time. Thus, if e i is the productivity (or effort) of person i and t i is the time spent folding letters, then according to the PLL it holds that e i (t i ) = gt η i with 0 < η < 1. Where g and η are parameters describing the learning ability of the individual. We cannot rule out that the participants in our experiments differ with respect to these parameters. In principle, it is possible to estimate g and η but this would make it necessary to observe the productivity of each individual over the entire time they spend in the laboratory. We decided against this because if a person is observed that closely, it would surely influence his or her behavior. However, we controlled for demographic parameters like gender, education and age. We found that age has a significant influence on productivity but that controlling for this does not change the treatment effects. This gives us confidence that the randomization was successful and the productivity parameters are equally distributed over the treatments. 3.1 Tax effect: tax-free, 25% tax, and 50% tax treatments In line with the empirical results of Gensemer et al. (1965), Morgan et al. (1977), Lewis (1978), Bartolome (1995), Rupert and Fischer (1995), and Chetty et al. (2009), we conjecture that individuals misperceive the tax effect. Even though the perceived tax burden ˆτ is not observable, the effort levels will depend on participant tax perception. Therefore, we can use the observed effort levels in our different tax treatments to characterize tax perception at least in a qualitative way. According to equation 3, the necessary condition for the payoff maximizing effort is: c(e i ) = w ˆτ = w τ τ (4) In order to analyze tax-effect biases, we consider three treatments with identical net wage rates of 9 euro-cents per produced item but with different tax rates and gross wage rates adjusted accordingly. In the tax-free treatment, no taxation is applied. In the 25% tax treatment (50% tax treatment), the gross wage rate is 12 (18) eurocents, but now it is taxed at a constant rate of 25% (50%). With respect to equation 2 Despite this difficulty, we decided to leave the decision on the length of the experiment to the subjects, because our aim was to create a real work-leisure decision. 3 See Mincer (1958), Ritter and Schooler (2001), and Richter (2011). 5

9 4, the term w τ, which determines the true marginal net wage rate, is the same in all three treatments (9 cents). Therefore, the effort should be the same in all treatments if no tax misperception exists ( τ = 0). Recall that for linear tax scales τ and τ are constant. The last term can be interpreted as the fraction of the tax that is not correctly realized as a tax. In line with the empirical results of Bartolome (1995) and Chetty et al. (2009), we expect that participants underestimate the tax effect. In our model, this is represented by a negative value of τ. For a constant (marginal and average) tax rate (as in our 25% and 50% tax treatments), τ is also constant and negative. Since the cost function is assumed to be convex, subjects effort in both tax treatments should be greater than subjects effort in the tax-free treatment. This leads us to the following hypothesis: Hypothese 1 (part 1): Participants effort level is lower in the tax-free treatment than in the 25% tax treatment and 50% tax treatment. Based on our assumptions regarding the relationship between the perceived and true tax rate (see figure 1), the tax bias τ in the 25% tax treatment can be equal, higher, or lower than the tax bias in the 50% tax treatment. However, if we assume that an increase of the (average and marginal) tax rate from 25% to 50% leads to a decline in tax misperceptions, a lower effort should be observed in the 50% tax treatment than in the 25% tax treatment for a constant gross wage rate w. In order to compare the efforts, the net wage rates in the linear tax treatments have to be identical. Therefore, the gross wage rate in the 50% treatment has to be higher than in the 25% treatment. Comparing the 25% and the 50% treatments we need to consider both the increase of the gross wage rate and the effect of a higher tax rate on the tax perception. Both effects will work in different directions. For a given tax misperception (a given constant fraction of the true tax that is ignored) an increase of the gross wage rate will lead to higher efforts. On the other hand, a higher tax rate will make the tax more salient and this will result in a lower tax misperception (a smaller fraction of the true tax is ignored) and, therefore, in a lower effort level. However, we conjecture that the first effect will not dominate the second. Therefore, we obtain the following hypothesis: Hypothese 1 (part 2): Participants effort level in the 50% tax treatment is not higher than in the 25% tax treatment. 6

10 marginal tax rate 60 % 50 % 40 % 30 % 20 % 10 % 0 % gross income in Euro direct progressive tax indirect progressive tax Figure 2: Marginal tax rates in the progressive tax treatments 3.2 Tax presentation effect: indirect (-), indirect (+), direct (-), and direct (+) tax treatments The next hypothesis concerns the presentation of complex tax scales. We conjecture that the more transparent the presentation of a tax scale, the smaller the tax perception bias. To test this hypothesis, we apply two progressive tax scales: an indirect progressive tax on earned income in the indirect (-) and indirect (+) tax treatments and a direct progressive tax in the direct (-) and direct (+) tax treatments. The gross wage rate is identical in all of these four treatments. The indirect progressive tax scale consists of a tax-free bracket up to euros and a constant marginal tax of 50% starting at euros. The direct progressive tax scale mimics the actual German income tax scale. Between 0 and 5 euros there is no taxation. Between 5 and 8 euros the marginal tax rate increases from 15% to 25%. Between 8 and (approximately) 42 euros the marginal tax rate increases from 25% to 50% and for all incomes above 42 euros the marginal tax rate is constant at 50%. Figure 2 displays the marginal tax rates of both progressive tax scales. To test the effect of more or less transparent tax presentations, both progressive tax scales are presented in two different ways. In the indirect (-) [direct (-)] tax treatment, the indirect [direct] progressive tax scale is only described verbally and in the indirect (+) [direct (+)] tax treatment a graphical illustration is added. Figure 3 shows how the direct progressive tax is illustrated graphically (the graph for the indirect tax is similar). To analyze the influence of transparency on tax perception, only the effort difference between the indirect (-) and indirect (+) as well as between the direct (-) and direct (+) is of importance. According to equation 4, the term w τ is unaffected by the tax presentation within each progressive tax scale. However, the explicit 7

11 1. Part: 0.00 to 5.00 no taxation 2. Part: 5.01 to 8.00 tax rate increases from 15 % to 25 % 3. Part: 8.01 to tax rate increases from 25 % to 50 % 4. Part: more than (constant) tax rate: 50 % 0 % 0 % 0 % 0 % 0 % 15 % 20 % 25 % % % % 50 % 50 % 50 % 50 % 1. Euro 2. Euro 3. Euro 4. Euro 5. Euro 6. Euro 7. Euro 8. Euro 9. Euro 10. Euro 39. Euro 40. Euro 41. Euro 42. Euro 43. Euro total tax: 0.00 total tax: 0.60 total tax: total tax: 50 Cent for each Euro exceeding total tax: 0.60 total tax: total tax: Cent for each Euro exceeding Figure 3: Graphical illustration of the direct progressive tax scale tax scale presentation in the indirect (+) and direct (+) tax treatments is expected to lead to a lower degree of tax misperception, i.e. τ indirect( ) τ indirect(+) and τ direct(+). Under the assumption that subjects also underestimate τ direct( ) progressive taxes, the effort should then be lower in the treatments with the explicit tax presentation. This leads to our second hypothesis: Hypothese 2: Participants effort level is lower in the indirect (+) [direct (+)] tax treatment than in the indirect (-) [direct (-)] tax treatment. 3.3 Tax experience effect: all treatments We conjecture that tax perception not only depends on the tax effect and the tax presentation effect, but also on individuals tax experience. For an individual to gain this experience, it is necessary to have a personal income that is high enough to create a tax obligation. In Germany, income taxation concentrates very much on higher incomes. Tax is payable on monthly incomes of more than 1,000 euros for single people and 1,700 euros for married people. Therefore, those subjects in our subject pool with an income below 2,000 euros are classified as subjects with no or only limited experience and those with an income above 2,000 euros are the experienced subjects. 8

12 Table 1: Characterization of treatments treatment tax scale gross wage rate marginal tax rate net wage rate tax scale presentation number of participants tax-free no taxation e 0.09 e % tax 50% tax indirect (-) indirect (+) direct (-) direct (+) proportional income taxation proportional income taxation indirect progressive taxation with tax-free bracket indirect progressive taxation with tax-free bracket direct progressive taxation direct progressive taxation e % e 0.09 no 36 e % e 0.09 no 31 e % or 50% (e 0.06; e 0.12) no 26 e % or 50% (e 0.06; e 0.12) yes 29 e 0.12 [0%; 50%] (e 0.06; e 0.12) no 27 e 0.12 [0%; 50%] (e 0.06; e 0.12) yes 36 We hypothesize that subjects with more tax experience are more aware of taxes τ inexperienced than inexperienced subjects and this higher sensitivity will lead to a more accurate τ tax perception. Therefore, experienced. In accordance with equation 4 and under the general expectation that the subjects will underestimate the taxes in all tax treatments, hypothesis 3 can be stated as follows: Hypothese 3: In all tax treatments, the effort levels of experienced subjects are lower than the levels of inexperienced subjects. Table 1 summarizes the characteristics of all seven treatments. 4 Experimental protocol The experiments were conducted at the experimental laboratory of the local university. Subjects were recruited randomly from the local telephone book. Potential subjects first received a letter in which they were informed that they could attend an experiment at the university if they were regularly employed with a minimum working time of 30 hours per week. A day later we called the subjects, asking if they fulfilled our requirements and if they were willing to participate. Those who agreed were invited to come to the laboratory in the late afternoon, after their regular working time. In total, 245 subjects participated. When they arrived at the laboratory, they received written instructions informing them about their task, the gross wage rate and the tax scale. The task was to fold letters and put them into 9

13 Table 2: Summary statistic over all treatments mean median standard deviation number of letters folded minutes in the lab effort net wage rate (in euro) Table 3: Effort levels (number of folded letters per minute) in the taxfree, 25% tax and 50% tax treatments treatment mean median standard deviation tax-free % tax % tax an envelope. The subjects were told that they could decide how long to stay in the laboratory. They could stop working whenever they wanted to and there was no time restriction. The subjects were located at computer desks, separated from each other, in soundproof booths. No communication was allowed during the experiment. Subjects were paid immediately after the experiment and received a show-up fee of 5 euros. 5 Results The subjects folded about 43,300 letters over all treatments. Table 2 summarizes the mean, median, and the standard deviation of the number of folded letters, the time spent in the laboratory, the effort and the realized net income over all treatments. The first hypothesis concerns the question of how subjects react to a simple flat tax. A comparison of the effort levels in the tax-free treatment with those in the 25% tax and 50% tax treatments clearly shows that the effort levels under a flat tax are higher than without taxation (see table 3 and figure 4). The differences between the tax-free and the 25% tax treatments and between the tax-free and the 50% tax treatments are highly significant (p = and 0.005, Mann-Whitney-U-test, two-sided). Obviously, the first part of hypothesis 1 can be confirmed. The subjects seem to ignore the flat tax to a great extent and demonstrate a kind of net-wage illusion. They behave as if a significant fraction of the 10

14 tax free 25% tax 50% tax Figure 4: Effort levels on average in the tax-free, 25% tax and 50% tax treatment tax is part of their net income. We can conclude that the tax bias τ is negative (i.e. an underestimation of the tax effect) in the 25% tax and 50% tax treatments. The second part of hypothesis 1 claims that an increase in the flat tax rate from 25% to 50% will increase the tax salience and, therefore, lead to a smaller tax bias. The data show that there is no significant difference between the efforts in the 25% tax and 50% tax treatments (p = 0.860, Mann-Whitney-U-test, two-sided). If it is true that the effort depends on the perceived net wage rate, this implies that the net wage rates in both tax treatments are perceived as identical. Obviously, the two effects described in section 3.1 cancel each other out. On the one hand, the increase in the gross wage rate (from 12 to 18 cent per letter) increases the perceived net wage rate for a given net-wage illusion. On the other hand, the increase of the tax rate makes taxation more salient, which leads to a lower tax misperception and, therefore, to a decrease in the perceived net wage rate. While the first effect makes the effort level go up, the second works in the opposite direction. Thus, the second part of hypothesis 1 is also confirmed. A higher tax rate increases the tax salience and leads to a smaller tax misperception. In order to test the second hypothesis, it is necessary to compare the results of the progressive tax treatments with and without the graphical illustration. Table 4 and figure 5 show the effort levels in these treatments. As a result, the graphical presentation of the tax leads to lower effort levels for both kinds of progressive tax scales. The fact that this is only weakly significant for the indirect progressive tax scale (p = 0.057) is surprising because the tax scale used in both the indirect (-) and the indirect (+) treatments is already very simple considering that it has only two marginal tax rates (0% and 50%). Nevertheless, explaining this simple form of taxation in more detail causes a significant decrease in the effort level. On the other hand, this is not true for the much more complex 11

15 Table 4: Effort levels in the treatments with a progressive tax scale treatment mean median standard deviation indirect (-) indirect (+) direct (-) direct (+) indirect (-) indirect (+) direct (-) direct (+) Figure 5: Effort levels on average in the treatments with a progressive tax scale tax scale in the direct (-) and direct (+) tax treatments. A possible explanation for this result is that the complexity of a tax scale is a determinant of its salience. The more complex taxes are, the more salient the taxation is. This interpretation is in line with the observation that the extremely simple tax scales in the 25% tax and 50% tax treatments are not perceived correctly. The last hypothesis concerns the role of experiences made with income taxation. Table 5 shows the average and median (in brackets) effort levels of experienced (high income) and inexperienced (low income) subjects. The distribution of experienced and inexperienced subjects in each treatment is presented in brackets in the first column and the p-value results from a Mann-Whitney-U-test (two-sided). Figure 6 plots the average effort levels of both subject groups. It turns out that experience with taxation does not provide any protection against tax perception bias at all. In the flat tax treatments, 25% tax and 50% tax, the higher income group always shows a higher effort level than the low income subjects (although not significantly). Experience becomes important when the tax scales become more complex. Starting with the indirect (-) treatment, the effort levels of the experienced subjects are always below those of the inexperienced. It is only in the direct (-) treatment, however, that the difference is significant. In this treatment, expert knowledge has the highest value because the tax scale is complicated and only described verbally. But the results of the direct (+) treatment demonstrate that 12

16 Table 5: Average and median (in brackets) effort levels of experienced and inexperienced subjects treatment inexperienced experienced p-value tax-free [19/41] (2.083) (2.281) % tax [6/29] (2.512) (2.380) % tax [10/19] (2.401) (2.818) indirect ( ) [15/11] (2.651) (2.393) indirect (+) [5/23] (2.108) (2.151) direct ( ) [10/16] (2.532) (2.162) direct (+) [15/17] (2.313) (2.000) tax free 25% tax 50% tax indirect (-) indirect (+) direct (-) direct (+) inexperienced subjects experienced subjects Figure 6: Average effort levels of experienced and inexperienced subjects 13

17 expert knowledge can be substituted by a better and more transparent presentation of the tax. Table 6 shows the results of a linear regression analysis with the effort level as the dependent variable. As independent variables, we use dummies for each treatment, which take the value of 1 if a subject participated in the respective treatment. The tax free treatment is the default and, therefore, the coefficient of a dummy variable measures the difference between the respective tax treatment and the tax free treatment. Furthermore, we include the information we obtained from an ex post questionnaire: dummies are introduced for gender (female = 0, male = 1), education (low educational level = 0, high educational level = 1) 4 and income (net household income per month below e 2,000 = 0, above e 2,000 = 1). Furthermore, we use a dummy which takes the value of 1 if the person is in an executive position, a dummy for brain work (no brain work = 0, brain work = 1), and a dummy for the question of whether the person had worked the day the experiment was carried out (if yes then worked today = 1). The variable age is measured on a 6-point scale from 1 (20 25) to 6 (older than 65). We further asked the subjects how they felt at work in general ( value work ) and how exhausting they found the experiment ( experiment exertion ). Both were measured on a 10-point scale from 1 (totally dissatisfied / relaxing) to 10 (deeply satisfied / exhausting). The variable hours per week indicates the number of hours a participant works per week on average. We consider the results of all the subjects in model 1 and 2, whereas we split the subject pool into those who earned more than 2,000 euros (experienced subjects) and those with an income below that level (inexperienced subjects) in models 3 and 4 to control for the experience effect. In general, the results of our regression analyses are in line with our previous findings. With respect to model 1 and 2, we find a significant increase in the effort in both flat tax treatments. This increase is also observed in the other models for both experienced and inexperienced subjects, however, the difference is not significant at all. In (nearly) all models, we observe a somewhat smaller increase in the 50% tax treatment than in the 25% tax treatment which confirms our conjecture that a higher tax rate increases tax salience and, therefore, decreases tax misperceptions. Furthermore, the analyses confirm our observation that a more transparent tax presentation reduces tax biases (except for the inexperienced subjects with the indirect progressive taxation). 4 Low educational level includes the answers: no completed apprenticeship, completed apprenticeship, and master craftsman. High educational level includes the answers: college (university of applied sciences) degree and university degree. 14

18 Table 6: Linear regressions with effort as dependent variable model 1 model 2 model 3 model 4 all all inexp. exp. inexp. exp. subjects subjects subjects subjects subjects subjects constant 2.283*** 2.658*** 2.171*** 2.335*** 2.972*** 2.497*** 25% tax 0.403*** 0.279** ** * 50% tax 0.321** 0.265* * indirect (-) 0.286* ** indirect (+) * * * direct (-) * direct (+) age *** ** *** gender *** * *** education hours worked brain work executive position worked today value work 0.054** ** experiment exertion income R adjusted R model s p-value *** p < 0.01, ** p < 0.05, * p < 0.1 The results of model 3 and 4 reveal a strong tax experience effect in the complex tax treatments. Compared to the results of the tax free treatment, inexperienced subjects increased their effort in all progressive tax treatments, but experienced subjects did not. In nearly all of these treatments, subjects with tax experience actually decreased their effort. However, in the direct tax treatment, the large difference between the groups vanishes when individuals received a graphical illustration of the tax system. Therefore, we can conclude that a very transparent tax presentation can compensate for tax inexperience. With respect to demographic variables, we observe that age, gender, and value work have a significant negative impact on effort. However, controlling for these effects does not change the significant treatment effects we have already detected. 15

19 6 Discussion The experimental results reported in this paper demonstrate that the perception of taxes can be heavily biased. Surprisingly, it turns out that most notably very simple forms of taxation are in danger of causing tax perception bias. The strongest form of misperception was observed when the labor income was subject to a flat tax of 25%, with our non-student subjects increasing their effort significantly as compared to the subjects in the tax-free treatment. The tax rate itself is also a determinant of tax perception. The stronger the taxation, the more salient the tax even a simple flat tax. A possible explanation for the higher effort levels in the treatments with 25% and 50% taxes could be that subjects like to work for the government or derive utility from producing public goods. If this is a true explanation, however, we should not observe that subjects work less hard if they are more aware of the tax. But the results of our last four treatments show that this is precisely what happens. A promising way to overcome the misperception of taxes is their transparent presentation. Once again, this is particularly true for simple taxes. Progressive tax scales with more than one marginal tax rate have a higher salience, simply because they are more complex. Nevertheless, a graphical illustration also improves the correctness of tax perception for these tax scales. Experience with taxation does not prevent taxpayers from experiencing a netwage illusion when taxes are simple and, therefore, not salient. It does, however, become valuable when taxes are more complicated and in need of more transparent explanation. Furthermore, this experience can be supplemented with a clear presentation of complicated tax scales so that people with little, or no, tax experience also have a fair chance of perceiving taxes as they are. Appendix A Instructions The instructions of all the treatments differ only in one specific passage. Therefore, we first present the general instructions, which are identical in all the treatments, and then the specific instructions of each treatment. The instructions were originally written in German. 16

20 A.1 General instructions By participating in this experiment, you have the opportunity to earn money. The payoff at the end of the experiment depends on your individual effort. Please read the instructions carefully. If you have any further questions, please ask the experimenter. Primary note: The aim of this experiment is to obtain information about the individual labor supply. For this purpose you will be confronted with a real work task, with which you earn money. To compare the data of various research participants, a work task has been chosen in such a way that absolutely no previous knowledge or special talent is required and that it is easy to measure. Procedure: We would like to point out that communicating with other participants or leaving your seat is not allowed for the duration of the whole experiment. After reading the instructions, you will receive letters and envelopes. Your task is to fold these letters and to put them into the envelopes. Please seal the envelopes. The letters are used to acquire research participants in Magdeburg. You determine your working time yourself. This means that there is no time limit and you can stop the experiment at any time. Afterwards, you will receive your payoff in accordance with the following rule and you are then allowed to leave the laboratory. [specific instructions of a treatment] After this experiment, we will ask you to fill out a short questionnaire. We would like to emphasize that we do not record you name at any time and, therefore, all your statements remain anonymous. Enjoy yourself! A.2 Specific instructions of the tax-free treatment You will receive a payoff at the end of the experiment that depends on the number of letters folded and put into envelopes. You will receive 9 cents for each letter. If you fold on average 2 letters per minute, this leads to an hourly wage of euros, 2.5 letters to euros and 3 letters to euros. The money you earn will be paid to you in cash at the end of the experiment. 17

21 A.3 Specific instructions of the 25% tax treatment You will receive a payoff at the end of the experiment that depends on the number of letters folded and put into envelopes. You will receive 12 cents for each letter. If you fold on average 2 letters per minute, this leads to an hourly wage of euros, 2.5 letters to euros and 3 letters to euros. A tax at a rate of 25% will be deducted from your earned amount, and the rest will be paid to you in cash at the end of the experiment. A.4 Specific instructions of the 50% tax treatment You will receive a payoff at the end of the experiment that depends on the number of letters folded and put into envelopes. You will receive 18 cents for each letter. If you fold on average 2 letters per minute, this leads to an hourly wage of euros, 2.5 letters to euros and 3 letters to euros. A tax at a rate of 50% will be deducted from your earned amount, and the rest will be paid to you in cash at the end of the experiment. A.5 Specific instructions of the indirect (-) and indirect (+) tax treatment You will receive a payoff at the end of the experiment that depends on the number of letters folded and put into envelopes. You will receive 12 cents for each letter. If you fold on average 2 letters per minute, this leads to an hourly wage of euros, 2.5 letters to euros and 3 letters to euros. Your income will not be subject to a tax up to an earned amount of euros. A tax at a rate of 50% will be deducted from each amount above euros, and the rest will be paid in cash to you at the end of the experiment. A.6 Specific instructions of the direct (-) and direct (+) tax treatment You will receive a payoff at the end of the experiment that depends on the number of letters folded and put into envelopes. You will receive 12 cents for each letter. If you fold on average 2 letters per minute, this leads to an hourly wage of euros, 2.5 letters to euros and 3 letters to euros. A tax will be deducted from your earned amount, and the rest will be paid to you at the end of the experiment in cash. The tax burden depends on your total amount and is determined as follows: 18

22 Bracket 1: Your total amount is between 0.00 euros and 5.00 euros: If your total amount is not higher than 5.00 euros, no tax will be imposed. Bracket 2: Your total amount is between 5.01 euros and 8.00 euros: A tax is deducted from each amount above 5.00 euros. The tax rate uniformly increases from 15% (at 5.01 euros) to 25% (at 8.00 euros) in this bracket. Bracket 3: Your total amount is between 8.01 euros and euros: If your total amount is in this bracket, a lump sum tax of 0.60 euros will be levied. In addition to this tax, a further tax is deducted from each amount above 8.00 euros. The tax rate uniformly increases from 25% (at 8.01 euros) to 50% (at euros) in this bracket. Bracket 4: Your total amount is above euros: If your total amount is in this bracket, a lump sum tax of euros will be levied. In addition to this tax, a further tax is deducted from each amount above euros. The tax rate is always 50%. 19

23 B Raw Data subject treatment folded letters time (min) effort (letters per min) tax experience 1 tax-free inexperienced 2 tax-free inexperienced 3 tax-free inexperienced 4 tax-free inexperienced 5 tax-free inexperienced 6 tax-free inexperienced 7 tax-free inexperienced 8 tax-free inexperienced 9 tax-free inexperienced 10 tax-free experienced 11 tax-free experienced 12 tax-free experienced 13 tax-free experienced 14 tax-free experienced 15 tax-free experienced 16 tax-free experienced 17 tax-free experienced 18 tax-free experienced 19 tax-free experienced 20 tax-free experienced 21 tax-free experienced 22 tax-free experienced 23 tax-free experienced 24 tax-free experienced 25 tax-free inexperienced 26 tax-free inexperienced 27 tax-free inexperienced 28 tax-free inexperienced 29 tax-free inexperienced 30 tax-free inexperienced 31 tax-free inexperienced 32 tax-free inexperienced 33 tax-free inexperienced 34 tax-free inexperienced 35 tax-free experienced 36 tax-free experienced 37 tax-free experienced 38 tax-free experienced 39 tax-free experienced 20

24 40 tax-free experienced 41 tax-free experienced 42 tax-free experienced 43 tax-free experienced 44 tax-free experienced 45 tax-free experienced 46 tax-free experienced 47 tax-free experienced 48 tax-free experienced 49 tax-free experienced 50 tax-free experienced 51 tax-free experienced 52 tax-free experienced 53 tax-free experienced 54 tax-free experienced 55 tax-free experienced 56 tax-free experienced 57 tax-free experienced 58 tax-free experienced 59 tax-free experienced 60 tax-free experienced 61 25% tax inexperienced 62 25% tax inexperienced 63 25% tax inexperienced 64 25% tax inexperienced 65 25% tax experienced 66 25% tax experienced 67 25% tax experienced 68 25% tax experienced 69 25% tax experienced 70 25% tax experienced 71 25% tax experienced 72 25% tax experienced 73 25% tax experienced 74 25% tax experienced 75 25% tax not stated 76 25% tax inexperienced 77 25% tax inexperienced 78 25% tax experienced 79 25% tax experienced 80 25% tax experienced 81 25% tax experienced 82 25% tax experienced 21

25 83 25% tax experienced 84 25% tax experienced 85 25% tax experienced 86 25% tax experienced 87 25% tax experienced 88 25% tax experienced 89 25% tax experienced 90 25% tax experienced 91 25% tax experienced 92 25% tax experienced 93 25% tax experienced 94 25% tax experienced 95 25% tax experienced 96 25% tax experienced 97 50% tax not stated 98 50% tax not stated 99 50% tax inexperienced % tax inexperienced % tax inexperienced % tax inexperienced % tax inexperienced % tax inexperienced % tax experienced % tax experienced % tax experienced % tax experienced % tax inexperienced % tax inexperienced % tax inexperienced % tax inexperienced % tax experienced % tax experienced % tax experienced % tax experienced % tax experienced % tax experienced % tax experienced % tax experienced % tax experienced % tax experienced % tax experienced % tax experienced % tax experienced 22

26 126 50% tax experienced % tax experienced 128 indirect (-) inexperienced 129 indirect (-) inexperienced 130 indirect (-) inexperienced 131 indirect (-) inexperienced 132 indirect (-) inexperienced 133 indirect (-) inexperienced 134 indirect (-) inexperienced 135 indirect (-) inexperienced 136 indirect (-) experienced 137 indirect (-) experienced 138 indirect (-) experienced 139 indirect (-) experienced 140 indirect (-) experienced 141 indirect (-) experienced 142 indirect (-) inexperienced 143 indirect (-) inexperienced 144 indirect (-) inexperienced 145 indirect (-) inexperienced 146 indirect (-) inexperienced 147 indirect (-) inexperienced 148 indirect (-) inexperienced 149 indirect (-) experienced 150 indirect (-) experienced 151 indirect (-) experienced 152 indirect (-) experienced 153 indirect (-) experienced 154 indirect (+) not stated 155 indirect (+) inexperienced 156 indirect (+) inexperienced 157 indirect (+) inexperienced 158 indirect (+) experienced 159 indirect (+) experienced 160 indirect (+) experienced 161 indirect (+) experienced 162 indirect (+) experienced 163 indirect (+) experienced 164 indirect (+) experienced 165 indirect (+) experienced 166 indirect (+) experienced 167 indirect (+) inexperienced 168 indirect (+) inexperienced 23